Chapter 7.1: Introduction to Fundamental Analysis of Stocks

In recent years, investor interest in the Indian equity market has grown tremendously. In 2014 alone, National Securities Deposit Limited (NSDL) and Central Depository Services Limited (CDSL)—the two national depositories—added 13 lakh new investor accounts. Although the high return potential of equity markets attract many investors, few are prepared for the massive losses that investing in wrong stocks can bring. It is, therefore, critical to understand the companies one invests in before investing in them. One method of equity analysis that is often used is called Fundamental analysis.

What is fundamental analysis of stocks

Fundamental analysis is when an investor analyses a company’s future profitability based on its business environment and financial performance. Both qualitative and quantitative aspects of the company are considered. On the basis of these aspects, you – the investor – decide whether or not to invest in the shares of the company. The basic idea here is to assess general efficiency of a company’s operations, its future growth and profit-making potential.

Fundamental analysis is distinct from the other branch of equity analysis called technical analysis. There, not much attention is paid to the financial performance of the company. Investment decisions are taken based on patterns of the company’s historical share price.

Types of Fundamental Analysis – Qualitative and Quantitative

Fundamental analysis is of two types—qualitative and quantitative. In the first, you try to assess the key, quantifiable aspects of the performance of a company. In the second, you seek to develop an understanding of the important aspects that cannot be explained in numbers. Qualitative analysis is, therefore, also informally referred to as hygiene check. Here’s a look at these two concepts:

Types of Fundamental Analysis

Qualitative analysis :

Quantitative analysis has a distinct advantage—it reduces the entire analysis down to a few numbers. However, it also has certain limitations. It is not able to capture the critical qualitative aspects of a business. The quality of a company’s management, for example, is critical to investors. However, there is no way of quantifying it. This can be done using qualitative analysis.

Qualitative analysis is not formula driven. Quality is something subjective. It has to be judged individually by each investor. Some of the answers investors seek when conducting quantitative analysis relate to a company’s industry structure, quality of management, incomes and expenses, corporate governance and assets and liabilities. Some of these have been listed below. We look at them in detail in the following sections.

Nature of business :

How profitable is the industry the company operates in? What is the expected industry growth rate?

How easy is it for new companies to enter the industry (entry barriers) and gain the market share of existing companies?

Who dominates the market- companies in the industry, customers or suppliers?

How much bargaining power do they have?

Corporate governance :

Corporate governance refers to the set of practices a company has put in place to ensure shareholders’ interests are put foremost in its dealings. The two most important legal requirements that companies have to adhere to in this respect is the setting up of a board of directors to promote the interest of shareholders and performing periodic audits to ensure that its accounts are in order.

Some of the questions related to corporate governance that investors seek answers to are:

What is the size of the board of directors?

How many independent directors are there on the board?

Are the independent directors truly independent or are they related to the management in some way (such as close family, former employees etc.), such that they will promote its interests over the shareholders’?

How frequently are the company’s accounts audited? How independent are these auditors?

Nature of assets and liabilities :

What are the assets the company has invested in? How old are these?

How much is the company investing in the replacement and maintenance of old assets?

What new assets is the company investing in? Are they going to contribute to an increase in future earnings? Do they indicate a shift to a different industry/ product offering?

How are the assets financed – debt/ own funds/ issuance of new shares? Will they generate enough income to repay the debt?

How much debt does the company have?

What is the company using its debt for?

Quality of earnings :

What is the key source of the company’s earnings – its core operations or other sources that may not persist in future periods?

What proportion of the company’s income is in cash? Future receivables?

What proportion of the income is non-cash, such as revaluation gains?

What are the principal expenses? Are they expected to recur?

What proportion of the expenses are non-cash, such as depreciation?

Quantitative analysis :

This is the aspect of fundamental analysis that allows you to understand the financial performance of a company through few numerical values. You then compare them with performance data of other, similar companies as well as historical performance of the same company. This helps you ascertain how a company is performing relative to its peers and its own prior performance, in previous years.

Quantitative analysis is generally conducted using financial ratios or earnings projections. Data for such analysis are taken from the income statement and the balance sheet – the two basic financial statements of the company. A third important financial statement – the cash flow statement – is also considered.

The balance sheet is a statement of a company’s assets – what it owns, and liabilities – what it owes, at a particular point of time. The income statement talks about the company’s revenues, expenses incurred and profit or loss made during a certain period. It helps investors get a sense of the company’s income from different sources; what expenses it has to undertake in order to generate this income, and whether the company is earning enough to meet its financial obligations. The cash flow statement concentrates specifically on the movement of cash in and out of the business. After all, companies don’t often receive or pay money immediately after or before sales. So, the flow of money may differ from the actual revenues and expenses incurred.

There are two key aspects oF a quantitative analysis

What Comprises Quantitative Analysis

Ratio analysis :

This approach entails the calculation of certain basic ratios to comment about the performance of a company during a period and the price of its shares compared to those of the other companies. There are five sets of ratios that are calculated for a company. These include – activity or efficiency ratios, liquidity ratios, solvency ratios, profitability ratios, and market multiples. A detailed discussion on these can be found in the section on ratio analysis here.

Projected earnings :

As with everything that can be bought, the value of a share to you, the buyer, is equal to the future benefit you expect to get from it. The benefit you get out of investing in shares is price appreciation and a periodic dividend the company pays on these shares. Dividend is a part of the company’s income for a year that it distributes to shareholders as cash. Therefore, how much dividend you will get in future is directly connected to a company’s future earnings. So, it is important to project dividends expected in future.

Secondly, shares of a company will normally appreciate if you expect its earnings to grow in future. Thus, if you can somehow project a company’s future earnings, you can calculate the price you should be willing to pay for one share of the company. This process is called earnings projections. To estimate future earnings, you also have to estimate future sales, income from other sources and the expenses of the company. Further, sales will only grow if the company has assets to produce more goods in the future. For this, it will also require more funds, which it will raise through debt and issuance of more equity shares. Thus, you have to project all the financial statements of the company. To do so, you use the company’s historic performance and certain estimates to make these projections. These will be discussed in detail later, in the section on equity valuation.

Relationship between Quantitative and Qualitative analysis :

Qualitative and Quantitative analysis are mutually fulfilling. There are aspects of both that cannot be captured by the other. Thus, investors normally use both of them together. Quantitative analysis is more of an analysis of ‘what’. It seeks to explain what a company’s financial statements look like today and what they could look like in the future. Qualitative analysis, on the other hand, is an analysis of ‘how’. It tries to find the reasons within the company that will help it succeed in future. It also explains why the figures calculated using quantitative analysis look the way they do.

One approach that ties the two together is called the economy-industry-company (EIC) or top-down framework. It starts with a broad view of the entire economy to identify specific industry sectors (such as IT, banking and pharmaceutical) that could perform well, given recent developments. Then, it narrows down to specific companies within the sectors that are worth investing in. While the first step of the analysis is more qualitative, a quantitative aspect kicks in in the last two.

What next?

Now, we have understood the basics of a stock market like the different kinds of stocks and indices and how the share market works. So let us move on to some company-related financial information in the next section about annual reports. This is important because you need to analyze stocks and the underlying companies before buying. Reading financial reports will help you garner knowledge about the profitability and invest wisely. click here.

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